CHAPTER 2: INTEREST RATE

Lecturer: Truong Thi Thuy Trang

Email: [email protected]

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Content
• Measuring interest rate
• The behavior of interest rate
• Risk structure of interest rate
• Term structure of interest rate

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Interest Rates: Interpretation
• An interest rate, denoted r, is a rate of return that
reflects the relationship between differently dated
cash flows.
• Interest rates can be thought of in three ways.
– First, they can be considered required rates of return -
that is, the minimum rate of return an investor must
receive in order to accept the investment.
– Second, interest rates can be considered discount rates.
– Third, interest rates can be considered opportunity costs.

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Interest Rates: Interpretation
Interest rate = Real risk-free interest rate
+ Inflation premium
+ Default risk premium
+ Liquidity premium
+ Maturity premium

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Interest Rates: Interpretation
• The real risk-free interest rate is the single-
period interest rate for a completely risk-free
security if no inflation were expected.
• The inflation premium compensates investors for
expected inflation and reflects the average
inflation rate expected over the maturity of the
debt.

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Interest Rates: Interpretation
• The default risk premium compensates investors
for the possibility that the borrower will fail to make
a promised payment at the contracted time and in
the contracted amount.
• The liquidity premium compensates investors for
the risk of loss relative to an investment’s fair
value if the investment needs to be converted to
cash quickly.

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Interest Rates: Interpretation
• The maturity premium compensates investors
for the increased sensitivity of the market value of
debt to a change in market interest rates as
maturity is extended, in general (holding all else
equal).

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Interpretation of Interest Rate
• Each individual requires different rate of returns
on the same assets, based on their level of risk
tolerance. Highly risk-adverse investors required
higher returns.
• However, many financial assets are traded in the
markets. Their prices (and rates of return) are set
at the equilibrium of demands and supplies or at
arbitrage-free prices. The rates of return set by the
market is called the market rates of return.

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Interpretation of Present Value
• Different debt instruments have very different streams
of cash payments to the holder known as cash flows
(CF).
• All else being equal, debt instruments are evaluated
against one another based on the amount of each
cash flow and the timing of each cash flow.
• This evaluation, where the analysis of the amount and
timing of a debt instrument’s cash flows lead to its
yield to maturity or interest rate, is called present
value analysis.
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Present Value Concept: Simple Loan Terms
• Loan Principal: the amount of funds the lender provides
to the borrower.
• Maturity Date: the date the loan must be repaid; the Loan
Term is from initiation to maturity date.
• Interest Payment: the cash amount that the borrower
must pay the lender for the use of the loan principal.
• Simple Interest Rate: the interest payment divided by the
loan principal; the percentage of principal that must be
paid as interest to the lender. Convention is to express on
an annual basis, irrespective of the loan term.

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Present Value Concept: Simple Loan Terms

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Present Value Concept: Simple Loan Terms
• A simple loan of $100 requires the borrower to
repay $100 principal plus $10 interest one year
from now. For this simple loan, the interest
payment expressed as a percentage of the
principal is a sensible way of measuring the
interest rate.

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Interest rate and time value of money
• The future value of an amount of money after n years
– Interest is paid once per year

FV = PV (1+ i)n

– Interest is paid m times per year

mn
⎛ in ⎞
FV = PV ⎜1+ ⎟
⎝ m⎠
– Interest is paid continuously:

FVn= PV ein

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Example: You are the lucky winner of your state’s
lottery of $5 million after taxes. You invest your
winnings in a five-year certificate of deposit (CD) at
a local financial institution. The CD promises to pay
7 percent per year compounded annually. This
institution also lets you reinvest the interest at that
rate for the duration of the CD. How much will you
have at the end of five years if your money remains
invested at 7 percent for five years with no
withdrawals?

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Example: An Australian bank offers to pay you 6
percent compounded monthly. You decide to invest
A$1 million for one year. What is the future value of
your investment if interest payments are reinvested
at 6 percent?

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Example: Suppose a $10,000 investment will earn
8 percent compounded continuously for two years.
What is the future value of this investment?

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Yield to Maturity
• Yield to maturity (YTM) is the interest rate that
equates the present value of cash flow payments
received from a debt instrument with its value
today
• Yield to maturity is the rate required in the market
on a bond.
• Financial economists consider YTM the most
accurate measure of interest rate.

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Yield to Maturity
• Simple loan
• Fixed payment loan
• Coupon bond
• Zero-coupon bond
• Perpetuity

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Yield to Maturity - Simple loan

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Yield to Maturity - Fixed payment loan

Ta có:
FP FP FP
LV = + +... +
(1+YTM )1 (1+YTM )2 (1+YTM )n

FP ⎡ 1 ⎤
LV = ⎢1− ⎥
YTM ⎣ (1+YTM )n ⎦

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Yield to Maturity - Fixed payment loan
Example: You decide to purchase a new home and
need a $100,000 mortgage. You take out a loan
from the bank that has an interest rate of 7%. What
is the yearly payment to the bank to pay off the loan
in 20 years?

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Yield to Maturity - Fixed payment loan
Example: Calculate the yield to maturity for a fixed
payment loan with the loan amount of $2500 and
required payments of $315 per year for 25 years.
The payments start in 2 years (at the end of the
year).

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Yield to Maturity - Fixed payment loan

⎡1− (1+YTM )−n ⎤

LV = FP ⎢ ⎥(1+YTM )
⎣ YTM ⎦
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Yield to Maturity - Fixed payment loan
Example: Calculate the yield to maturity for a fixed
payment loan with the loan amount of $2500 and
required payments of $315 per year for 25 years.
The payments start in 2 years (at the beginning of
the year).

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Yield to Maturity - Coupon bond

C C C F
P= + +... + +
(1+YTM )1 (1+YTM )2 (1+YTM )n (1+YTM )n

⎡1− (1+YTM )−n ⎤ −n

P = C⎢ ⎥ + F(1+YTM )
⎣ YTM ⎦

F−P
C+
YTM ≈ n
F + 2P
3

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Yield to Maturity - Fixed payment loan
• Example: Calculate the yield to maturity for a
fixed payment loan with the loan amount of $2500
and required payments of $315 per year for 25
years. The payments start in 2 years (at the
beginning of the year).

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Yield to Maturity - Coupon bond
Example: The Xanth bond has an annual coupon of
$80. Similar bonds have a yield to maturity of 8
percent. The Xanth bond will pay $80 per year for
the next 10 years in coupon interest. In 10 years,
Xanth will pay $1,000 to the owner of the bond.
What would this bond sell for?

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Yield to Maturity - Coupon bond

Example: A bond has a coupon rate of 14 percent,

then the owner will get a total of $140 per year, but
this $140 will come in two payments of $70 each.
The yield to maturity is quoted at 16 percent. What
would this bond sell for?

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Yield to Maturity - Zero-coupon bond

F F
P= n
⇒ YTM = n −1
(1+YTM ) P

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Yield to Maturity - Perpetuity

C ⎡ 1 ⎤ C
P= ⎢1− ∞⎥
=
YTM ⎣ (1+YTM ) ⎦ YTM

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Yield to Maturity - Perpetuity

Example: The British government once issued a

type of security called a consol bond, which
promised to pay a level cash flow indefinitely. If a
consol bond paid £100 per year in perpetuity, what
would it be worth today if the required rate of return
were 5 percent?

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Effective Annual Rate
• Interest rates on loans and saving accounts are
usually stated in the form of an annual percentage
rate (APR) with a certain frequency of
compounding.
– Example: A bank quotes an interest of 8% per annum
(called simple annual rate) with quarterly compounding.
What is the effective annual rate (equivalent annual
interest rate)?
m
⎛ APR ⎞
EAR = ⎜1+ ⎟ −1
⎝ m ⎠
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Effective Annual Rate
Example: What are the effective anuual rates of the
following:
• 12% APR compounded monthly?
• 10% APR compounded annually?
• 6% APR compounded daily?

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Continuous compounding rate
• Example: A bank quotes an interest of 8% per
annum (called simple annual rate) with quarterly
compounding. What is the equivalent rate with
continuous compounding?

i
icont = m. ln(1 + )
m

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Distinction Between Real and Nominal
Interest Rates
• Real interest rate
1. Interest rate that is adjusted for expected
changes in the price level
ir = i - p e

2. Real interest rate more accurately reflects true

cost of borrowing
3. When the real rate is low, there are greater
incentives to borrow and less to lend

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Real and Nominal Interest Rates
Example: What is the real interest rate if the
nominal interest rate is 8% and the expected
inflation rate is 10% over the course of a year?

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Real and Nominal Interest rates (Three-Month
Treasury Bill), 1953 -2016

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Distinction Between Interest Rates and Returns

• Rate of Return: we can decompose returns into

two pieces:
C Pt+1 − Pt
R= +
Pt Pt

• Where: = Current yield

= Capital gain

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Current Yield
C
ic =
P
• Current yield (CY) is just an approximation for
YTM – easier to calculate. However, we should
be aware of its properties:
1. If a bond’s price is near par and has a long maturity,
then CY is a good approximation.
2. A change in the current yield always signals change in
same direction as yield to maturity
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Distinction Between Interest Rates and Returns

Example: What would the rate of return be on a

bond bought for $1,000 and sold one year later for
$800? The bond has a face value of $1,000 and a
coupon rate of 8%.

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 One-Year Returns on Different-Maturity 10% Coupon Rate
Bonds When Interest Rates Rise from 10% to 20%

(1) (2) (3) (4) (5)

Years to Maturity Initial Initial Price Rate of (6)
When Bond Is Current Price Next Capital Gain Rate of Return
Purchased Yield (%) ($) Year* ($) (%) [col (2) + col (5)] (%)
30 10 1,000 503 −49.7 −39.7
20 10 1,000 516 −48.4 −38.4
10 10 1,000 597 −40.3 −30.3
5 10 1,000 741 −25.9 −15.9
2 10 1,000 917 −8.3 +1.7
1 10 1,000 1,000 0.0 +10.0

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One-Year Returns on Different-Maturity 10%-Coupon-Rate
Bonds When Interest Rates Fall from 10% to 5%

(1) (2) (3) (4) (5)

Years to Maturity Initial Initial Price Rate of (6)
When Bond Is Current Price Next Capital Gain Rate of Return
Purchased Yield (%) ($) Year* ($) (%) [col (2) + col (5)] (%)
30 10 1,000
20 10 1,000
10 10 1,000
5 10 1,000
2 10 1,000
1 10 1,000

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Maturity and the Volatility of Bond
Returns: Interest-Rate Risk
• The sensitivity of the price of a bond to the interest
rate is known as interest rate risk, and is captured
by the slope of the price-yield curve
• We have seen that, for a given coupon rate, bonds
with long maturities have greater interest rate risk
than bonds with short maturities; similarly, for a
given maturity, bonds with low coupons have
greater interest rate risk than bonds with high
coupons

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Maturity and the Volatility of Bond
Returns: Interest-Rate Risk
• Prices and returns for long-term bonds are more
volatile than those for shorter-term bonds.
• There is no interest-rate risk for any bond whose
time to maturity matches the holding period.

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Reinvestment risk
• Reinvestment risk occurs because of the need to “roll over”
securities at maturity, i.e., reinvesting the par value into a new
security.
• Problem for bond holder: The interest rate you can obtain at roll
over is unknown while you are holding these outstanding securities.
• Issue: What if market interest rates fall?
• You will then re-invest at a lower interest rate than the rate you had
on the maturing bond.
• Potential reinvestment risk is greater when holding shorter term
fixed income securities.
• With longer term bonds, you have locked in a known return over
the long term.

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Maturity and the Volatility of Bond Returns
• Key findings
1. Only bond whose return = yield is one with
maturity = holding period
2. For bonds with maturity > holding period, i ­ P ¯
implying capital loss
3. Longer is maturity, greater is price change
associated with interest rate change
4. Longer is maturity, more return changes with
change in interest rate
5. Bond with high initial interest rate can still have
negative return if i ­
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Yield on a Discount Basis
(F - P) 360
idb = ´
F (number of days to maturity)

• One –Year Bill (P = $900, F = $1000)

$1000 - $900 360
idb = ´ = .099 = 9.9%
$1000 365

• Two Characteristics
1. Understates yield to maturity; longer the maturity,
greater is understatement
2. Change in discount yield always signals change in
same direction as yield to maturity
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The behavior of interest rate
• Determinants of Asset Demand
• Supply and Demand in the Bond Market
• Changes in Equilibrium Interest Rates

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Determinants of Asset Demand
• An asset is a piece of property that is a store of value.
Facing the question of whether to buy and hold an asset or
whether to buy one asset rather than another, an individual
must consider the following factors:
1. Wealth, the total resources owned by the individual, including all
assets

2. Expected return (the return expected over the next period) on

one asset relative to alternative assets

3. Risk (the degree of uncertainty associated with the return) on

one asset relative to alternative assets

4. Liquidity (the ease and speed with which an asset can be

turned into cash) relative to alternative assets
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Expected Return
Re =p1R1 + p2R2 + … + pnRn

Where:
• Re = expected return
• n = number of possible outcomes (states of nature)
• Ri = return in the ith state of nature
• pi = probability of occurrence of the return Ri

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Expected Return
• What is the expected return on the Exxon-Mobil
bond if the return is 12% two-thirds of the time and
8% one-third of the time?

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Risk
• Risk: the degree of risk or uncertainty of an
asset’s returns also affects demand for the asset.
• We can use a measure of risk called the standard
deviation.
s = p1 ( R1 - R ) + p2 ( R2 - R ) + ... + pn ( Rn - R )
e 2 e 2 e 2

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• Consider two assets, stock in Fly-by-Night Airlines
and stock in Feet-on-the- Ground Bus Company.
Suppose that Fly-by-Night stock has a return of
15% half of the time and 5% the other half of the
time, making its expected return 10%, while stock
in Feet-on-the-Ground has a fixed return of 10%.
• What is the standard deviation of the returns on
the Fly-by-Night Airlines stock and Feet-on-the
Ground Bus Company, with the same return
outcomes and probabilities described above? Of
these two stocks, which is riskier?
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Determinants of Asset Demand
• The quantity demanded of an asset differs by factor.
1. Wealth: Holding everything else constant, an increase in wealth
raises the quantity demanded of an asset

2. Expected return: An increase in an asset’s expected return

relative to that of an alternative asset, holding everything else
unchanged, raises the quantity demanded of the asset

3. Risk: Holding everything else constant, if an asset’s risk rises

relative to that of alternative assets, its quantity demanded
will fall

4. Liquidity: The more liquid an asset is relative to alternative

assets, holding everything else unchanged, the more desirable
it is, and the greater will be the quantity demanded
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Determinants of Asset Demand

Variable Change in Variable Change in Quantity

Demanded
Wealth ↑ ↑

Expected return relative to other assets ↑ ↑

Risk relative to other assets ↑ ↓

Liquidity relative to other assets ↑ ↑

Note: Only increases in the variables are shown. The effect of decreases in the variables on the change
in quantity demanded would be the opposite of those indicated in the far-right column.

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Loanable Funds Framework

F-P
i=R = e

P
• Where:
i = interest rate = yield to maturity
Re = expected return
F = face value of the discount bond
P = initial purchase price of the discount bond

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Loanable Funds Framework

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Shifts in the Demand Curve

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Factors That Shift Supply Curve

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How Factors Shift the Demand Curve
1. Wealth/saving
– Economy ­, wealth ­
– Bd ­, Bd shifts out to right
OR
– Economy ¯, wealth ¯
– Bd shifts out to left

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How Factors Shift the Demand Curve
2. Expected Returns on bonds
– i ¯ in future, Re for long-term bonds ­
– Bd shifts out to right
OR
– πe ¯, relative Re ­
– Bd shifts out to right

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How Factors Shift the Demand Curve
2. …and Expected Returns on other assets
– ER on other asset (stock) ­
– Re for long-term bonds ¯
– Bd shifts out to left

These are closely tied to expected interest rate

and expected inflation

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How Factors Shift the Demand Curve
3. Risk
– Risk of bonds ¯, Bd ­
– Bd shifts out to right
OR
– Risk of other assets ­, Bd ­
– Bd shifts out to right

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How Factors Shift the Demand Curve
4. Liquidity
– Liquidity of bonds ­, Bd ­
– Bd shifts out to right
OR
– Liquidity of other assets ¯, Bd ­
– Bd shifts out to right

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Summary of Shifts in the Demand for Bonds
1. Wealth: in a business cycle expansion with
growing wealth, the demand for bonds rises,
conversely, in a recession, when income and
wealth are falling, the demand for bonds falls

2. Expected returns: higher expected interest

rates in the future decrease the demand for
long-term bonds, conversely, lower expected
interest rates in the future increase the demand
for long-term bonds
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Summary of Shifts in the Demand for Bonds
3. Risk: an increase in the riskiness of bonds
causes the demand for bonds to fall, conversely,
an increase in the riskiness of alternative assets
(like stocks) causes the demand for bonds
to rise
4. Liquidity: increased liquidity of the bond market
results in an increased demand for bonds,
conversely, increased liquidity of alternative
asset markets (like the stock market) lowers the
demand for bonds
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Shifts in the Supply Curve

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Factors That Shift Supply Curve

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Shifts in the Supply Curve
1. Profitability of Investment Opportunities
– Business cycle expansion,
– investment opportunities ­, Bs ­,
– Bs shifts out to right
2. Expected Inflation
– πe ­, Bs ­
– Bs shifts out to right
3. Government Activities
– Deficits ­, Bs ­
– Bs shifts out to right
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Summary of Shifts in the Supply of Bonds
1. Expected Profitability of Investment Opportunities:
in a business cycle expansion, the supply of bonds
increases, conversely, in a recession, when there are far
fewer expected profitable investment opportunities, the
supply of bonds falls

2. Expected Inflation: an increase in expected inflation

causes the supply of bonds to increase

3. Government Activities: higher government deficits

increase the supply of bonds, conversely, government
surpluses decrease the supply of bonds
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Case: Fisher Effect
• Recall that rates are composed of several
components: a real rate, an inflation premium, and
various risk premiums.
• What if there is only a change in expected
inflation?

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Changes in πe: The Fisher Effect

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Evidence on the Fisher Effect in the United States

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Summary of the Fisher Effect
1. If expected inflation rises from 5% to 10%, the expected
return on bonds relative to real assets falls and, as a
result, the demand for bonds falls
2. The rise in expected inflation also means that the real
cost of borrowing has declined, causing the quantity of
bonds supplied to increase
3. When the demand for bonds falls and the quantity of
bonds supplied increases, the equilibrium bond
price falls
4. Since the bond price is negatively related to the interest
rate, this means that the interest rate will rise

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Case: Business Cycle Expansion

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Evidence on Business Cycles and Interest Rates

76
Case: Low Japanese Interest Rates
• In November 1998, Japanese interest rates on
six-month Treasury bills turned slightly negative.
How can we explain that within the framework
discussed so far?

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Case: Low Japanese Interest Rates
1. Negative inflation lead to Bd ­
• Bd shifts out to right

2. Negative inflation lead to ¯ in real rates

• Bs shifts out to left
Net effect was an increase in bond prices (falling
interest rates).

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Case: Low Japanese Interest Rates
3. Business cycle contraction lead to ¯ in interest
rates
• Bs shifts out to left
• Bd shifts out to left
But the shift in Bd is less significant than the shift in Bs, so
the net effect was also an increase in bond prices.

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Risk Structure of Long Bonds in the U.S

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Risk Structure of Long Bonds in the U.S
• The figure show two important features of the
interest-rate behavior of bonds.
• Rates on different bond categories change from
one year to the next.
• Spreads on different bond categories change from
one year to the next (The spread between the
interest rate on Baa corporate bonds and U.S.
government bonds is very large during the Great
Depression)
81
Factors Affecting Risk Structure
of Interest Rates
• Default Risk
• Liquidity
• Income Tax Considerations

82
Default Risk
• Default risk: the issuer of the bond is unable or unwilling to
make interest payments when promised.
• U.S. Treasury bonds have usually been considered to have no
default risk because the federal government can always
increase taxes to pay off its obligations (or just print money) →
Default-free bonds.
• The spread between the interest rates on bonds with default risk
and default-free bonds, called the risk premium.
• A bond with default risk will always have a positive risk premium,
and an increase in its default risk will raise the risk premium.

83
84
Ratings
• Independent companies (rating agencies) have arisen to evaluate the
creditworthiness of potential borrowers

• The best known bond rating services are Moody’s, Standard & Poor’s,
Fitch

• They monitor the status of individual bond issuers and assess the
likelihood a lender will be repaid by the bond issuer
• A high rating suggests that a bond issuer will have little problem
meeting a bond’s payment obligations

• Firms or governments with an exceptionally strong financial position

carry the highest ratings and are able to issue the highest-rated bonds,
Triple A
– E.g., the U.S. Government, ExxonMobil, Microsoft
85
Ratings
• The top four categories are considered
investment- grade bonds
• Speculative grade bonds are bonds issued by
companies and countries that may have difficulty
meeting their bond payments but are not at risk of
immediate default
• Highly speculative bonds include debts that are in
serious risk of default
• Both speculative grades are often referred to as
junk bonds or high-yield bonds 86
Ratings
• The distinction between investment-grade and speculative,
noninvestment-grade bonds is important
– A number of regulated institutional investors are not allowed to
invest in bonds rated below Baa on Moody’s scale or BBB on
Standard and Poor’s scale

• Bond ratings may change over time. Material changes in a

firm’s or government’s financial conditions precipitate
changes in its debt ratings
– Ratings downgrade - lower an issuer’s bond rating.

– Ratings upgrade - upgrade an issuer’s bond rating.

87
88
89
Annual Credit Loss Rates for Corporate Bonds, 1983–
2015

90
Annual Credit Loss Rates for Corporate Bonds, 1983–
2015

91
Liquidity
• The lower a security’s liquidity, the higher the yield
preferred by an investor.
• Debt securities with a short-term maturity or an
active secondary market have greater liquidity.

92
Income Tax Considerations
• Investors are more concerned with after-tax
income.
• Taxable securities must offer a higher before-tax
yield.

93
Income Tax Considerations
• Computing the Equivalent Before-Tax Yield:

g at = g bt (1 - T )
g at = after-tax yield
g bt = before-tax yield
T = Investor’s marginal tax rate
g at
g bt =
(1 - T )
94
Risk Structure of Interest Rate
Interest rate = Risk Free Rate
+ (Inflation Premium)
+ Default Risk Premium
+ Liquidity Risk Premium
+ (Maturity Risk Premium)
+ (Tax Discrepancy Premium)

95
 Movements over Time of Interest Rates on U.S.
Government Bonds with Different Maturities

Sources: Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2/

96
Term Structure of Interest Rates
• Yield curve
• Spot rates and forward rates.
• Three Facts that the Term Structure of Interest
Rates must explain

97
Term Structure of Interest Rates
The term structure of interest
rates is the relation between
Sample Term Structure different interest rates for
11% different term-to-maturity
loans.
Spot Rate

10%
If we observe:
9%
r1 = 8%,
8%
r2 = 9%,
7%
r3 = 9.5%,
1 2 3 4 5
r4 = 9.75% and
Term to Maturity (Years) r5 = 9.875%
then the current term structure
The curve plotted through the above points of interest rates is represented
is also called the “yield curve” by plotting these “spot rates”
against their terms-to-maturity.

98
Spot Rates
• The n-period current spot rate of interest denoted rn is the
current interest rate (fixed today) for a loan (where the
cash is borrowed now) to be repaid in n periods.
• Spot rates are only determined from the prices of zero-
coupon bonds and are thus applicable for discounting cash
flows that occur in a single time period.
• This differs from the more broad concept of yield to
maturity that is, in effect, an average rate used to discount
all the cash flows of a level coupon bond.

99
Spot Rates and YTM
• Yield to maturity is just a complex, nonlinear
“average” of spot rates of interest.
– Because most of the bond’s cash flow arrives at
maturity (the principal), the T-year spot rate gets the
most weight in the yield-to-maturity calculation.
– High coupon bonds pay a larger percentage of their
face value as coupons than low coupon bonds; thus,
their yields-to-maturity give more weight to earlier spot
rates.

100
Spot Rates
• Suppose that the one-year spot rate is 2%, the
two-year spot rate is 3%, and the three-year spot
rate is 4%. en, the price of a three-year bond that
makes a 5% annual coupon payment is

101
Spot Rates
• This three-year bond is priced at a premium above
par value, so its yield-to-maturity must be less
than 5%.

102
Spot Rates
• When the coupon and principal cash flows are
discounted using the yield-to-maturity, the same
price is obtained.

103
Bond Prices and Yields-to-Maturity
Based on Spot Rates
• Calculate the price (per 100 of par value) and the
yield-to-maturity for a four-year, 3% annual
coupon payment bond given the following two
sequences of spot rates.

104
Forward Rates
• A forward market is for future delivery, beyond
the usual settlement time period in the cash
market. Agreement to the terms for the
transaction is on the trade date, but delivery of
the security and payment for it is deferred to a
future date. A forward rate is the interest rate on
a bond or money market instrument traded in a
forward market.
• The one-period forward rate of interest denoted fn
is the interest rate (fixed today) for a one period
loan to be repaid at some future time period, n.
105
Forward Rates
• Investing $1,000 in the two year zero coupon
bond at r2=9% gives $1,188.10 in 2 yrs. This is
equivalent to investing in the one year bond at
8%, giving $1,080 after 1 year, and then investing
in another 1 year bond at X% for the second year
to get $1,188.10.
• Solve for X . . . the forward rate.

106
Forward Rates
• To calculate a forward rate, the following equation
is useful:

1 + fn = (1+rn)n / (1+rn-1)n-1
– where fn is the one period forward rate for a loan repaid
in period n
§ (i.e., borrowed in period n-1 and repaid in period n)

– Calculate f2 given r1=8% and r2=9%

– Calculate f3 given r3=9.5%

107
Forward rates
• Suppose that in the cash market, a five-year zero-
coupon bond is priced at 81 per 100 of par value.
Its yield-to-maturity is 4.2592%, stated on a
semiannual bond basis.

108
Forward rates
• Suppose that a dealer agrees to deliver a five-
year bond two years into the future for a price of
75 per 100 of par value. The credit risk, liquidity,
and tax status of this bond traded in the forward
market are the same as the one in the cash
market. The forward rate is 5.8372%.

109
Forward rates
• 2y5y: the two-year into five-year rate,” or simply
“the 2’s, 5’s.” The idea is that the first number (two
years) refers to the length of the forward period in
years from today and the second number (five
years) refers to the tenor of the underlying bond.
The tenor is the time-to-maturity for a bond (or a
derivative contract).

110
Implied forward rates
• Implied forward rates (also known as forward
yields) are calculated from spot rates. An implied
forward rate is a break-even reinvestment rate. It
links the return on an investment in a shorter-term
zero-coupon bond to the return on an investment
in a longer-term zero-coupon bond.

111
Implied forward rates
• Suppose that the shorter-term bond matures in A periods
and the longer-term bond matures in B periods. The yields-
to-maturity per period on these bonds are denoted zA and
zB. The first is an A-period zero-coupon bond trading in the
cash market. The second is a B-period zero-coupon cash
market bond. The implied forward rate between period A
and period B is denoted IFRA,B–A. It is a forward rate on a
security that starts in period A and ends in period B. Its
tenor is B – A periods.

112
Computing Forward Rates
• Suppose that an investor observes these prices and
yields-to-maturity on zero-coupon government
bonds:

• The prices are per 100 of par value. The yields-to-

maturity are stated on a semiannual bond basis.

113
Computing Forward Rates
1. Compute the “1y1y” and “2y1y” implied forward rates, stated on a
semiannual bond basis.

2. The investor has a three-year investment horizon and is choosing

between (1) buying the two-year zero and reinvesting in another one-
year zero in two years and (2) buying and holding to maturity the three-
year zero. The investor decides to buy the two-year bond. Based on this
decision, which of the following is the minimum yield-to-maturity the
investor expects on one-year zeros two years from now?

• 2.548%

• 2.707%

• 2.983%

114
 Movements over Time of Interest Rates on U.S.
Government Bonds with Different Maturities

Sources: Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2/

115
Term Structure of Interest Rates
The theory of the term structure of interest rates
must explain the following facts:
1. Interest rates on bonds of different maturities move
together over time.

2. When short-term interest rates are low, yield curves

are more likely to have an upward slope; when short-
term rates are high, yield curves are more likely to
slope downward and be inverted.

3. Yield curves almost always slope upward.

116
Term Structure of Interest Rates
Three theories to explain the three facts:

1. Expectations theory explains the first two facts but not

the third.

2. Segmented markets theory explains the third fact but

not the first two.

3. Liquidity premium theory combines the two theories to

explain all three facts.

117
Expectations Theory
• The interest rate on a long-term bond will equal an
average of the short-term interest rates that people
expect to occur over the life of the long-term bond.
• Buyers of bonds do not prefer bonds of one maturity
over another; they will not hold
any quantity of a bond if its expected return
is less than that of another bond with a different
maturity.
• Bond holders consider bonds with different maturities
to be perfect substitutes.
118
Expectations Theory
An example:

• Let the current rate on one-year bond be 6%.

• You expect the interest rate on a one-year bond to be 8%

next year.

• Then the expected return for buying two one-year bonds

averages (6% + 8%)/2 = 7%.

• The interest rate on a two-year bond must be 7% for you to

be willing to purchase it.

119
Expectations Theory

For an investment of $1
it = today's interest rate on a one-period bond
ite+1 = interest rate on a one-period bond expected for next period
i2t = today's interest rate on the two-period bond

120
Expectations Theory

Expected return over the two periods from investing $1 in the

two-period bond and holding it for the two periods
(1 + i2t )(1 + i2t ) - 1
= 1 + 2i2t + (i2t ) 2 - 1
= 2i2t + (i2t ) 2
Since (i2t ) 2 is very small
the expected return for holding the two-period bond for two periods is
2i2t

121
Expectations Theory

If two one-period bonds are bought with the $1 investment

(1 + it )(1 + ite+1 ) - 1
1 + it + ite+1 + it (ite+1 ) - 1
it + ite+1 + it (ite+1 )
it (ite+1 ) is extremely small
Simplifying we get
it + ite+1

122
Expectations Theory

Both bonds will be held only if the expected returns are equal
2i2t = it + ite+1
it + ite+1
i2t =
2
The two-period rate must equal the average of the two one-period rates
For bonds with longer maturities
it + ite+1 + ite+ 2 + ... + ite+ ( n -1)
int =
n
The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the bond

123
Expectations Theory
• Expectations theory explains:
– Why the term structure of interest rates changes at
different times.
– Why interest rates on bonds with different maturities
move together over time (fact 1).
– Why yield curves tend to slope up when short-term
rates are low and slope down when short-term rates
are high (fact 2).

• Cannot explain why yield curves usually slope

upward (fact 3)
124
Segmented Markets Theory
• Bonds of different maturities are not substitutes at all.
• The interest rate for each bond with a different maturity
is determined by the demand for and supply of that
bond.
• Investors have preferences for bonds of one maturity
over another.
• If investors generally prefer bonds with shorter
maturities that have less interest-rate risk, then this
explains why yield curves usually slope upward (fact 3).

125
Liquidity Premium & Preferred
Habitat Theories
• The interest rate on a long-term bond will equal an
average of short-term interest rates expected to
occur over the life of the long-term bond plus a
liquidity premium that responds to supply and
demand conditions for that bond.
• Bonds of different maturities are partial (not
perfect) substitutes.

126
Liquidity Premium Theory

it + it+1
e
+ it+2
e
+ ...+ it+(
e

int = n-1)
+ lnt
n
where lnt is the liquidity premium for the n-period bond at time t
lnt is always positive
Rises with the term to maturity

127
Preferred Habitat Theory
• Investors have a preference for bonds of one
maturity over another.
• They will be willing to buy bonds of different
maturities only if they earn a somewhat higher
expected return.
• Investors are likely to prefer short-term bonds over
longer-term bonds.

128
The Relationship Between the Liquidity Premium
(Preferred Habitat) and Expectations Theory

129
Liquidity Premium & Preferred
Habitat Theories
• Interest rates on different maturity bonds move together
over time; explained by the first term in the equation
• Yield curves tend to slope upward when short-term rates
are low and to be inverted when short-term rates are high;
explained by the liquidity premium term in the first case
and by a low expected average in the second case
• Yield curves typically slope upward; explained by a larger
liquidity premium as the term to maturity lengthens

130
Yield Curves and the Market’s Expectations of Future
Short-Term Interest Rates According to the Liquidity
Premium (Preferred Habitat) Theory

131
A Closer Look at the Term Structure
• Uses of the term structure
– Forecast interest rates
§ Pure expectations and liquidity premium theories
can be used
– Forecast recessions
§ A flat or inverted yield curve may indicate a
recession in the near future since lower interest
rates are expected

132
A Closer Look at the Term Structure
• Uses of the term structure
– Investment decisions
§ Riding the yield curve involves investment in higher-yielding
long-term securities with short-term funds
§ Financial institutions whose liability maturities are different
from their asset maturities monitor the yield curve
– Financing decisions
§ Assessing prevailing rates on securities for various maturities
allows firms to estimate the rates to be paid on bonds with
different maturities

133
A Closer Look at the Term Structure
• Impact of debt management on term structure
– If the Treasury uses a relatively large proportion of long-term debt,
this places upward pressure on long-term yields
– If the Treasury uses short-term debt, long-term interest rates may
be relatively low
• Historical review of the term structure
– Early 1980s: downward sloping yield curve
– 1982 to 2001: an upward sloping yield curve generally persisted
– September 11, 2001: investors shifted funds into short-term
securities and the Fed provided funds to the banking system,
causing the yield curve to become steeper

134
Yield Curves for U.S. Government Bonds

135